Quasi-Legal In China. Not The Place You Want To Be.

This post is essentially a re-running of a post we did at the end of last year. We are re-running it because as China’s economy starts to waver, the Chinese government seems to have stepped up both its tax collection and its closing of illegal foreign businesses another notch. I received two calls just last week from companies who were told that their “Rep Offices” were illegal and that they needed to form a WFOE right away or simply leave China.

Now is really not the time to be operating in quasi-legal mode in China. It just isn’t.

Every couple of weeks my firm gets an email or a phone call from a small business that is seeking to justify forming a Rep Office in China instead of a Wholly Foreign Owned Enterprise (WFOE). These small businesses typically go into advocacy mode explaining why their business can and should be a Rep Office in China. They then go on to explain that they simply cannot afford to form a WFOE in China due to the minimum capital requirements, the legal fees, and the taxes.

They then want me to condone their Rep Office plans but I never do.

In fact, the increasing number of these requests has caused me to get even blunter than usual, and my most recent response exemplifies this:

What you are describing doing as part of an RO [Rep Office] is definitely not proper for an RO. Not even close.

In terms of minimum capital required, because it is Dongguan, it is likely to be pretty high. Sorry.

You pretty much have two choices. You can operate completely off the grid and risk getting shut down, or you form a WFOE. Probably the worst thing you could do would be to form an RO that operates illegally because they you are just drawing attention to yourself.

I get the sense that the people contacting us on these things are hoping that they somehow have found THE loophole that nobody else has found and that if only they can get the blessings of an attorney for what they are doing, that their operating illegally will somehow not be illegal. I wish I had some magic oil I could sell (for a helluva lot of money) that I could sprinkle on illegal China businesses to make them legal, but I have no such thing.

Those who think they are going “sorta” legal by forming what is clearly an illegal Rep Office in China are very similar to those who think they are “sorta” protecting themselves legally by doing a “sorta” joint venture with their girlfriend. I wrote about those people in a post, entitled, “Operating Illegally In China. Half-Assing It Does Not Help.” In that post, I described the following email I had recently received from my co-blogger, Steve Dickinson:

We had one of these the other day and it precipitated an email from my co-blogger, Steve Dickinson, to me, which went as follows:

If these people are going to go illegal in China, they should go 100% illegal. That is, enforcement either through really strong family connections (your father knows her father) or enforcement through gangsters and the like. I know people who have succeeded this way but I don’t know anyone who has succeeded with an illegal contract. This is not because contracts don’t work in China, because you and I have won enough China contract cases to know that they do.

It is because the Chinese judges are totally on to these sorts of arrangements and they know they violate or seek to evade Chinese law. They therefore have and will continue to deem such contracts void. Why do people live in this fantasy world thinking that somehow they are so different or that they have discovered the solution? Why do they think a Chinese court would enforce a contract designed to evade the law?

Take an alternative example. Remember John Smith’s [yes, it is an alias] company we formed in Beijing a few years ago? Not sure if you remember this, but that investment was with his Chinese wife. However, we did that as a very formally organized WFOE and left the wife and her family with the irregular side of the deal. His US company is the only shareholder and he runs the board. His company has had no trouble and he has had no trouble because he is legal and secure. His US LLC [and with it, the China WFOE] were just purchased by _______ [a pretty big name U.S. company]. The reason the purchase was successful is that the whole company was “clean” and therefore it could be purchased by a foreign public company.

I then concluded that post with the following:

As lawyers we are never going to tell our client to go full illegal, but in my role as a blogger, I have to think going full illegal would probably make better sense than paying a lawyer to draft a void contract. I think people know this, but their rightful discomfort at operating illegally makes them want to clutch on to something that will allow them to justify (however falsely) their actions.

The same holds true with respect to forming a Rep Office when a WFOE is required. Forming the Rep Office in that situation will just serve to let the Chinese government know where you are and what you are doing and will make it easy for them to realize that what you are doing requires a WFOE. On top of that, as I am always saying, you should not form a Rep Office with plans to form a WFOE in a year or so “if everything works out.” You should not do this because you will end up paying THREE times as you will pay for forming the Rep Office, pay for shutting down the Rep Office (and this is not cheap), and then pay for forming the WFOE.

What really drives me crazy about all this though is that on at least three occasions, companies for whom we have refused to form Rep Offices have written me to tell me that “so and so” company formation company is willing to form the Rep Office for them, as though this mere fact means that my firm was wrong in declining to take money to do something we know will eventually not work.

And though I take no happiness from this, I will note that one of the three companies that went ahead and formed a Rep Office against our advice did contact us about a year later to tell us that the Chinese government was now making them form a WFOE.

For more on what is involved in forming a company in China, check out the following:

Dan Harris is internationally regarded as a leading authority on legal matters related to doing business in China and in other emerging economies in Asia. Forbes Magazine, Business Week, Fortune Magazine, BBC News, The Wall Street Journal, The Washington Post, The Economist, CNBC, The New York Times, and many other major media players, have looked to him for his perspective on international law issues.

Have you watched the documentary “Brits Get Rich In China” from the year 2007? It’s on youtube, and shows three Brits not getting scammed by Chinese and making millions!

Mi Fu

I think forming a Representative Office is still an attractive option for foreign SME.
The standard situation: An SME is starting to sell their products to the Chinese market, their Rep Office focusses on establishing a distributor network in China, gives technical support and training, organizes participation in trade fairs. Import is done via a local Import/Export company.
Everything 100% legal and rather simple.
If you want to upgrade to a foreign invested company and for example do the import yourself, you have to employ additional personnel to handle customs clearance and logistics. This pays off if your sales in China exceeds are certain amount.
I don’t agree that upgrading a Rep Office to a company is a big issue. It needs good planing to ensure that the company becomes operational before the Rep Office is closed, but it possible to do all this work without the help of a lawyer or a consultant, at least in Beijing and Shanghai, where procedures are rather transparent.

I really agree with Dan and Steve. Even on the Mi Fu example above, I’d recommend not using an RO (if client really opposes setting up a WFOE) and let Chinese distributors contract directly with client’s foreign entity to import and sell the products in question (using an enforceable Chinese contract–a whole separate issue). An RO is not even needed, let alone appropriate, and the size of sales are not the “tripping point” (last I checked!) between a foreigner’s setup of a RO versus a WFOE. ROs can’t conduct business in China, period.
One other point to mention is that unlike the “old days,” ROs are no longer quick to be formed, either. At least in geographical commercial centers, they are “low priority” entities for being formed, simply as they can’t do business, and there are plenty of real, business-hungry waiting WFOEs to be set up, with real capital, in the meantime.
I have a client in this precise (RO vs WFOE, for sale of products into China) position right now, and my suggestion is that if it can’t afford a WFOE, then it should not to set up an entity in China now. It claims to have a “trusted” Chinese importer/distributor for its products already, and an RO really would be utterly useless. Someday, client may want more and bigger and more diverse distribution in China, and then will need a WFOE. But RO is indeed a step “backward,” as Dan and Steve both note. Foreign company can still apply for trademark registrations on its products (not yet well known) in China (and could later assign the registrations on, to its WFOE, or to whatever “trustworthy” Chinese entities client thinks it may find, if enforcement is ever needed). That’s one of many huge risks with avoiding establishing a WFOE now. But setting up a RO is NOT a real step toward mitigating that risk, and in fact may create many more problems than it could possibly solve.

@DLW,
Nicely put. I fear that many entity formation companies are still encouraging Rep Offices even though they do not make sense. They are still pretty easy to form (in terms of the workload for the entity formation company) and I think some of these entity formation companies will not tell their clients to either do a WFOE or not bother, simply because they do not want to turn down the fees from the Rep Office.
There are still rare instances where Rep Offices make sense, but those are extremely few and far between.

VP

You are so right. I operated totally illegally in Shenzhen for more than two years and then I needed to start looking legal for a big United States company with which I was doing business and within three months of that, I stopped being able to get a visa and my employees took over my business. I am not sure if this happened to me because I became more visible or if my employees ratted me out so they could take over. No big loss though as I was thinking of moving back to the States anyways.

JL

My company is investigation about a R.O. in China. In our country we offer service to local companies and foreing to sell/buy by themselves products in china. As the distance and time difference makes the bussiness quite slow we are thinking moving and open an R.O. in china. This office will not buy or sell in china, but the main office or my customers will do that. I’ll be in chine looking for suppliers, making quality control of products for my customers or introducin to chinese companies my customer in order to chinese companies buy to my customers. Is this activity dangerous for my business? I’ll not pay to anyone, but it’s posible the main office in my country does and only check the papers, quantities, quality, etc.
What do you think about this? Best regards, and thanks in advance for your comments.
JL

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We will be discussing the practical aspects of Chinese law and how it impacts business there. We will be telling you what works and what does not and what you as a businessperson can do to use the law to your advantage. Our aim is to assist businesses already in China or planning to go into China, not to break new ground in legal theory or policy.